When it comes to personal finance, one of the biggest debates has always been around active vs passive income.
Which one offers more benefits? What are the pros and the cons of each? And most importantly, how can you generate either or both?
This article will answer these questions, giving you a comprehensive guide on using passive and active income to reach your financial goals.
What is active income?
Active income is what you earn from working.
It's your job, your career, and your business. This type of income requires ongoing effort to maintain and grow.
Active income examples
Active income can come in many forms, including job wages, business profits, freelance work, and consulting. For example:
Job (wages, tips, commissions)
Earned through employment, such as a regular paycheck, tips for service jobs, or commissions for sales positions.
Earned through business activities, such as selling products or services, the owner actively manages and makes decisions for the business.
Earned by providing client services on a project-by-project basis rather than as an employee.
Earned by providing expert advice and guidance to clients on a specific topic or industry.
Advantages of active income
The primary benefit of active income vs passive income is that it provides a regular stream of income that individuals can rely on.
Whether working a job, running a business, freelancing, or consulting, you can generally count on receiving a consistent paycheck or payment for your work.
Disadvantages of active income
The most significant disadvantage of active income is that it requires time and energy.
You must actively work and put effort into your job or business to earn income. This can be time-consuming and limit your ability to pursue other interests or hobbies.
Additionally, your income stream may be interrupted if you become sick or are otherwise unable to work.
How is active income taxed?
When you earn an active income, it may be subject to federal, state, and also local income taxes.
The amount you owe will depend on several factors, including your income level, filing status, and any deductions or credits you're eligible for.
Let's take a closer look:
Federal income tax
The amount you owe is based on a progressive tax system, meaning the more money you earn, the higher your tax rate.
However, with active income, there are several deductions and credits you may be eligible for that can reduce your taxable income and then lower your tax bill.
State income tax
The amount you owe will depend on your state, your income level, and other factors (such as how long you lived in that state during the year).
Some states have a flat tax rate, while others use a progressive system like the federal government.
Local income tax
Typically collected by cities or towns, based on the income you earn while working within their boundaries.
It's also important to note that in addition to income tax, you may be subject to other taxes on your active income, such as Social Security and Medicare.
What is passive income?
Passive income refers to earnings that are generated without active involvement or effort. However, this type of income requires an initial investment or some hard work.
Still, it can generate income without ongoing effort.
Passive income examples
Passive income can come in many forms, including market investments, interest, royalties, and rental income.
Here are the descriptions for each:
Profits that result from the sale of an asset, such as stocks, real estate, or other investments. It is the difference between the purchase price and the selling price of the asset.
Payments made to shareholders by a company from its profits. They are typically paid out in cash or stock and paid quarterly or annually.
Earned from lending or having money in an interest-bearing account, such as your savings account or a CD.
Payments made to a patent, trademark, or copyright owner for the right to use that intellectual property.
Earned from renting out a property, such as a house, apartment, or commercial space.
Advantages of passive income
One of the primary benefits of passive income is the ability to earn money while you sleep.
Passive income streams can provide a steady source of income without requiring continuous effort or work. This can be beneficial for those who want to supplement their active income streams or retire early.
Another advantage of passive income is that it can be location independent. If you have a connection to the internet, you can earn passive income from anywhere in the world.
Disadvantages of passive income
One of the biggest drawbacks is that passive income can be less reliable than active income.
Passive income streams can fluctuate or disappear altogether, making it difficult to rely on them as a steady source of income.
Additionally, passive income often requires an initial investment of time or money upfront. For example, starting a rental property business requires a significant cash investment to purchase, make necessary repairs, and market the property to potential renters.
Tax implications of passive income
While earning passive income can be a great way to build wealth and achieve financial freedom, it's important to understand how it's taxed.
In most cases, passive income is subject to federal income tax and state income tax in the state where the income is earned.
However, the tax rate for passive income may differ from what you pay on active income, depending on the type of passive income and how it's earned.
To give you a better picture of what taxes may look like on passive income streams, the following list summarizes common tax treatments of the passive income opportunities we discussed above:
Short-term capital gains taxes
Gains from selling assets held for a year or less than a year are taxed at the same rate as ordinary income.
Long-term capital gains taxes
Gains from selling assets held for more than just one year are taxed at a rate lower than normal income.
Dividend income taxes
Qualified dividends are taxed at a lower rate than ordinary income, but non-qualified dividends are taxed at the same rate as normal income.
Interest income taxes
Subject to ordinary income tax rates, however, certain types of interest income, such as municipal bond interest, might be exempt from federal income tax.
Royalty income taxes
Generally taxed at the taxpayer's ordinary income tax rate.
Rental income taxes
Subject to ordinary income tax rates.
The difference between active and passive income streams
With a basic understanding of each type of income under your belt, we can now compare active vs passive income to help you determine which type of income may best suit your financial goals and lifestyle.
In particular, you'll want to consider the following:
- Earning potential and scalability
- Investments in time and money
Earning potential & scalability of active vs passive income
The first factor you will want to consider is the difference in earning potential and scalability between active and passive income streams.
Active income is limited by hours and education
Your earning potential from active income vs passive income is limited by the amount of work you put in.
For example, working full-time has a cap on earning potential based on hours worked and hourly wage/salary.
Career and education advancement can increase earning potential but require time and effort. Additional education or training can lead to higher-paying jobs but require significant investment.
However, advancing in your career may impact your work-life balance.
Passive income has fewer limitations after the income source is set up
Passive income streams generate revenue without ongoing input, making them attractive.
For example, rental properties, successful blogs, and online courses can generate income through advertising, affiliate marketing, and sponsored content.
Scaling is possible by expanding the source of income or creating additional streams.
And although a significant upfront investment in time and/or money is required, once established, passive income streams provide reliable and consistent income for long-term wealth.
Investments of time and money for active vs passive income
Next, consider how much time and cash you'll need to initiate and sustain active vs passive income.
Active income only makes money with constant effort and time
Active income needs consistent time and effort for revenue, meaning stopping work stops income. This requires steady work to ensure regular income, involving a significant investment of time, energy, and ongoing education to maintain earning potential.
Education, training, and development are crucial for active income, increasing earning potential, and opening job opportunities. However, it requires an investment of time and money.
Pursuing higher education or training courses can be costly but lead to higher salaries and better job prospects.
In addition, ongoing development and training help maintain earning potential and stay ahead of industry trends.
Active income usually has minimal initial financial investment, but starting a business or higher education may require steep upfront costs, such as equipment, marketing, tuition fees, or loans.
However, these investments can pay off in the long run by increasing earning potential and career advancement opportunities.
Passive income requires time and effort but not consistently
Initial investments to start with passive income streams vary; some require less capital than others. For example, real estate investments require more upfront than stocks or online courses.
Further, passive income streams require significant time and effort to set up, including research, planning, and creating a product or service. However, once established, they provide steady income with little ongoing effort.
Passive income can offer greater freedom and flexibility than traditional active income streams.
With passive income, individuals can generate revenue even when not actively working. This can allow for a more flexible schedule and the ability to pursue other passions or interests.
Risk of active vs passive income
Finally, research the risks of active vs passive income streams before going all-in with an opportunity. There is a large difference between active and passive income regarding risk.
Active income has risks like loss of larger income or potential failure
Active income vs passive income streams may seem less risky but it still has inherent risks.
For example, the fixed salary or wage in a contract means few opportunities for additional revenue, making it difficult to increase earnings even with more time and effort.
Plus, entrepreneurship or starting a business involves significant risks. It requires a substantial investment of time, effort, and money, with the risk of failure always present.
In addition, unexpected factors, such as changes in the market, can impact success despite careful planning and research.
Active income streams can also lead to burnout and career stagnation. The demands of a job can cause a lack of work-life balance and affect mental and physical health.
Without growth opportunities, employees may feel unfulfilled, decreasing motivation and earning potential.
Passive income has risks that may be beyond your control
Passive income streams require an upfront investment, which can be risky if returns are unstable. For instance, investing in rental properties or stocks may be profitable, but the market is unpredictable.
Further, passive income streams require ongoing maintenance and management, which may result in a loss of revenue if not properly handled.
For example, rental properties require tenant management and upkeep, while stocks and investments may require monitoring and adjustment.
External factors beyond their control can also impact passive income streams. For example, real estate investments can be affected by changes in the market, while fluctuations in the stock market may impact stocks.
How can one structure earning active vs passive income?
Passive vs active income doesn't need to be an either/or situation - there's room for both in your overall financial plan!
Ultimately, the structure of your earnings should be based on what works best for you and your situation.
For some people, a mix of passive and active income may be ideal. Others may prefer to put all their effort into generating passive income streams.
To start, look at your current earnings and see where they come from, and determine what works best for you, typically one of the following:
- Use active income to generate passive income
- Use active income to generate more active income
- Use passive income to generate active income
- Use passive income to generate more passive income
But no matter what approach you take, remember that it's essential to diversify your sources of income so that you're not too reliant on any one stream. This will help ensure you can still generate income even if one source dries up.
Active income to generate passive income
While earning an active income is important for paying the bills and supporting your lifestyle, you can also use that money to build long-term wealth and financial freedom by investing your active income in assets that generate passive income.
Simply funnel a percentage of your active income toward your passive income streams. This could be anything from rental properties and dividend-paying stocks to mutual funds and bonds.
Another way to create passive income is by starting a business or side hustle. This could be anything from an online store or blog to a rental property or e-book.
Active income to generate more active income
You can use the existing active income to create more active income!
A good way to do this is by investing in yourself and your career. This could mean taking on additional work or side hustles to increase your income or investing in education and professional development programs that can help you earn more money in your current job or industry.
Passive income to generate active income
Did you know you can use passive income to create active income streams?
One way to do this is by reinvesting your passive income into assets that generate active income. This could be anything from starting a new business, investing in a franchise, or launching a new product or service.
Passive income to generate more passive income
With a little bit of smart investing and dedication, you can use your passive income to create a powerful snowball effect of passive income that grows over time and supports your financial goals.
One way to do this is by reinvesting your passive income into additional passive income-generating assets. This could be anything from rental properties and dividend-paying stocks to bonds and mutual funds.
Another way to generate more passive income from your existing passive income is by using it to pay down debt or reduce expenses.
By paying off high-interest debt or decreasing your monthly bills, you can free up more money to invest in additional passive income-generating assets.
Active vs passive income: leverage both to achieve your financial goals!
The difference between active and passive income is that they present two very different routes for making money.
But both can be incredibly lucrative depending on your preferences, goals, and financial capabilities.